The impact of Basel III on Islamic banks: A theoretical study and comparison with conventional banks Adel HARZI Head of Capital Management Dexia Credit Local – Dexia SA

Chapter 1 – Impact of the new capital requirements and ratios on Chapter 1 – Impact of the new capital requirements and ratios on Islamic banks Basel Committee on Banking Supervision, (BCBS), an international organization which main objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide, has issued some reforms more know as Basel III. This framework is realized in order to prevent the financial system from future crisis. This framework is only propositions, but it really became a global standard as both the European Union (CRD41) and USA2 have decided to pass the BCBS regulation proposal into their legal frameworks. Basel III will have a major impact on the business plans and the strategy of conventional financial institutions. It will introduce a lot of modifications: new own funds and risk computations, new ratios, modification of the Tier 1 and Tier 2 category, new solvency ratios, new risk computations, new additional buffer and and new limits in terms of leverage and liquidity ratios.… As Basel II, Basel III will be a standard and in Europe, it will be an obligation for all the banks The main problematic, is Basel III, as Basel II, is currently not adapted for islamic banks. In an environment when a lot is islamic banks attempts to be compliant with Basel II (mainly in Malaysia and Middle East), what will be the real impact of this new regulation on islamic banks ? Moreover, we will see if, from a theoretical point of view, if the Basel III impact is more or less important in Islamic banks than in conventional one by analyzing each new reform and its potential impact in the structure of the two types of banks. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 1 – Overview of Basel III framework Basel III framework: an overview (1/3) Basel III: Capital and Leverage •More restrictive definition of capital •More demanding capital ratios, bigger capital buffers •Higher capital charges for counterparty risk •Formal leverage ratio Microprudential Basel III: Quantitative Liquidity Standard •Liquidity Coverage Ratio: to survive 1-month stress •Net Stable Funding Ratio: to require longer term funding source Reform Agenda Systemic Risk •SIFIs Too big too fail •Surcharges in Capital •OTC derivatives in central clearing institutions •Non-bank financial institution Two column bullet-pointed slide. Macroprudential New cross Border Resolution Countercyclical Provisioning 4

Chapter 1 – Overview of Basel III framework Basel III framework: an overview (2/3) Two column bullet-pointed slide. Source: Text 5

Chapter 1 – Overview of Basel III framework Basel III framework: an overview (3/3) Two column bullet-pointed slide. Source: Text 6

Chapter 1 – Overview of Basel III framework With Basel III, the regulator has decided to increase the importance of what we name the Tier 1 Capital, which is in fact the common equity and some hybrid capital (strict eligibility criteria). The definition of the Tier 2 Capital is reduced consequently and the Tier 3 is abrogated. Impact on islamic banks: Capital structure of islamic banks is not the same as the receipt and the payments of interest on instruments is prohibited (not Shariah compliant) This meaning that the elements that compunds Tier1, Tier 2 and Tier 3 is not the same as conventional banks can use debt instruments Composition of the Capital of an islamic banks: Essentially Tier 1 Capital (bank’s own capital). Having some Tier 2 in the capital of Islamic banks is very rare as in general it is capital or hybrid capital linked to the payment of interest Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 2 – Impact of the new capital requirements and ratios on Chapter 2 – Impact of the new capital requirements and ratios on Islamic banks Comparison of the impact: islamic vs conventional banks Tier 1 Basel III clearly has a positive impact in terms of competitively for the Islamic banks. Conventional banks will see their capital (all things being equal) decreased by a larger share than the Islamic banks This meaning that conventional banks will have a higher cost of funding (due mainly to the loss absorbing at the point of non viability) that all debt instruments should have since now (cost between 200 and 400 bps) Tier 2 the same phenomenon is likely to happen for Tier 2 ratios of the conventional banks: a strong decrease because of the new regulation. At the same time, he Islamic banks will still have a total capital ratio (Tier 1 + Tier 2) approximately equal to the past and equal to their Tier 1 ratio. Two column bullet-pointed slide.

Chapter 2 – Impact of the new capital requirements and ratios on Chapter 2 – Impact of the new capital requirements and ratios on Islamic banks Comparison of the impact: islamic vs conventional banks Tier 1 Basel III clearly has a positive impact in terms of competitively for the Islamic banks. Conventional banks will see their capital (all things being equal) decreased by a larger share than the Islamic banks This meaning that conventional banks will have a higher cost of funding (due mainly to the loss absorbing at the point of non viability) that all debt instruments should have since now (cost between 200 and 400 bps) Tier 2 the same phenomenon is likely to happen for Tier 2 ratios of the conventional banks: a strong decrease because of the new regulation. At the same time, he Islamic banks will still have a total capital ratio (Tier 1 + Tier 2) approximately equal to the past and equal to their Tier 1 ratio when conventional banks will see their own funds reduced by 10 to 30% according to Morgan Stanley study. Two column bullet-pointed slide.

Chapter 2 – Impact of the new capital requirements and ratios on Chapter 2 – Impact of the new capital requirements and ratios on Islamic banks Comparison of the impact: islamic vs conventional banks Tier 1 Basel III clearly has a positive impact in terms of competitively for the Islamic banks. Conventional banks will see their capital (all things being equal) decreased by a larger share than the Islamic banks This meaning that conventional banks will have a higher cost of funding (due mainly to the loss absorbing at the point of non viability) that all debt instruments should have since now (cost between 200 and 400 bps) Tier 2 the same phenomenon is likely to happen for Tier 2 ratios of the conventional banks: a strong decrease because of the new regulation. At the same time, he Islamic banks will still have a total capital ratio (Tier 1 + Tier 2) approximately equal to the past and equal to their Tier 1 ratio when conventional banks will see their own funds reduced by 10 to 30% according to Morgan Stanley study. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 3 – Basel III impact on the risk computation of islamic banks Impact of the Profit sharing investment accounts (PSIA) on the risk weighted assets and capital adequacy computation. Basel committee has done its framework for conventional banks and does not take into account specific features of Islamic banks, such as the Profit Sharing Investment Accounts. Although these assets do not imply financial risks for the bank (because the risk was taken by the investment account shareholders) for the bank, they are not considered as equity capital. According to the BCBS and under Basel III rules, the capital adequacy ratio should be over 8% today according to the following formula: Two column bullet-pointed slide.

Chapter 3 – Basel III impact on the risk computation of islamic banks IFSB (Islamic Financial Standard Board), an international institution created by Islamic banks and regulators, has issued some regulatory standard that constitute the equivalent of Basel II for Islamic banks. In 2005, IFSB has issued a guideline which help Islamic banks to compute a ratio equivalent to the Basel II capital adequacy ratio by in taking into account the PSIAs specificities. In effect, the capital amount of PSIA is not guaranteed by the Islamic bank. Any losses arising from investments or assets funded by PSIA are for the owners of theses PSIAs and so do not require any regulatory capital requirement. This implies that assets funded by restricted or unrestricted accounts of PSIAs should be excluded from the calculation of the denominator of the capital ratio. Two column bullet-pointed slide.

Chapter 3 – Basel III impact on the risk computation of islamic banks As a consequence of the last financial crisis, the Basel committee has decided to increase the amount of Risk weighted assets and specifically for the credit risk and the market risk… Basel III will introduce some measures in order to limit the credit risk due to counterparty credit exposures. It is in that perspective that they should stress their portfolio and compute an additional RWA compared to Basel II. They will also add a capital charge for credit valuation adjustment risk associated with deterioration of the credit quality of counterparty. Moreover, Basel III will improve the coverage of the risks related to capital market activities, especially counterparty credit risk on over the counter derivatives and in the trading book. Two column bullet-pointed slide.

Chapter 3 – Basel III impact on the risk computation of islamic banks Credit Risk One of the peculiar features of Islamic banks is that they have a credit risk higher than conventional banks. It is due to the importance of Mudarabah and Musharakah, and which are instruments held by the banks in their accounts for investment reasons and in general kept until their maturities. The predominance of credit based products imply for Islamic banks to be more exposed to the credit risk than conventional banks. Market Risk Historically, trading book businesses are less important in Islamic banks than in conventional banks because a non negligible part of the derivatives instruments used are not Shariah compliant and short selling is forbidden. So, as logic consequence, Islamic banks will not see their trading book very impacted by the changes in the new regulation. In the other hand, the products in the quasi trading books (as Salam and istisna contracts) may be more impacted mainly due to the fact that it is commodity structured products with a price which depends of the volatility of the markets. In the same way, the volatility will have a major impact on the stress test scenarios and will increase the capital requirements due to the price fluctuations of the assets and commodities theses recent years by the way of the Value at Risk. Two column bullet-pointed slide.

Chapter 3 – Basel III impact on the risk computation of islamic banks Credit Risk One of the peculiar features of Islamic banks is that they have a credit risk higher than conventional banks. It is due to the importance of Mudarabah and Musharakah, and which are instruments held by the banks in their accounts for investment reasons and in general kept until their maturities. The predominance of credit based products imply for Islamic banks to be more exposed to the credit risk than conventional banks. Market Risk Historically, trading book businesses are less important in Islamic banks than in conventional banks because a non negligible part of the derivatives instruments used are not Shariah compliant and short selling is forbidden. So, as logic consequence, Islamic banks will not see their trading book very impacted by the changes in the new regulation. In the other hand, the products in the quasi trading books (as Salam and istisna contracts) may be more impacted mainly becauset it is commodity structured products with a price which depends of the volatility of the markets. In the same way, the volatility will have a major impact on the stress test scenarios and will increase the capital requirements due to the price fluctuations of the assets and commodities theses recent years by the way of the Value at Risk. Two column bullet-pointed slide.

Chapter 3 – Basel III impact on the risk computation of islamic banks Comparison of the impact: islamic vs conventional banks Conventional Banks: The impact of these additional requirements (Asset Value Correlation, Counterparty credit Risk in the trading book, CVA for risk Charge, additional requirements for the securitization) will increase deeply the amount of RWA in the conventional banks. In fact, the larger the trading book of a bank, and proportionally the higher will be the increase of additional RWA specific to Basel III. Morgan Stanley estimates that the increase of RWA due to Basel III in conventional European banks will be between 10 and 30%. Due to the fact that European banks have generally a big trading book which is higher than in Islamic banks (Islamic institutions cannot invest in CDO, CDS, bonds, derivatives…). Islamic Banks: The major part of the additional RWA is linked to such instruments that Islamic banks do not hold in their portfolios, such as CDO, CDS, repos or interest rates swaps… we can argue that Islamic banks will experience a far lesser risk weighted assets increase than the conventional financial system. It is nevertheless impossible today to quantify this impact and it depends clearly of the trading portfolio structure of each bank. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 4 – Capital conservation buffer and countercyclical buffer in islamic banks Basel Committee has required to setup two buffers: a countercyclical buffer and a capital conservation buffer in order to prevent against a financial collapse. Capital conservation buffer The objective of the Capital conservation buffer is to absorb losses during periods of financial and economic stress: Equal to 2,5% of the RWA composed of common equity (Tier 1) assets If the banks has not enough capital for this buffer, Basel 3 restricts the distribution of dividends, share buybacks or bonus payments) until the ratio of 7% is respected (4.5% + 2.5%) The purpose is to achieve the broader macro prudential goal of protecting the banking sector from periods of excess aggregate credit growth. Buffer within a range of 0% – 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances Two column bullet-pointed slide.

Chapter 4 – Capital conservation buffer and countercyclical buffer in islamic banks Comparison of the impact: islamic vs conventional banks Islamic banks The objectives of theses 2 buffers are quite different from the investment risk reserve and the profit equalization reserve. The computation of theses buffers should take into account the specificities of the Islamic banks and especially the presence of profit sharing investment accounts. In fact, as investment account holders take a part of the risk, we should deduct from the total risk weighted assets the parts which depend from the PSIAs and compute, after deduction the required amount for the 2 buffers. In the same way, if some gains should be retained in order to attains the required ratio for the new buffers, we should not retains neither the earning of the investment account holders or from the two specific islamic reserves (PER and IRR). The reason is that these two reserves are not compounded from profit of the bank shareholders but from the profit of the investment account holders. Except this point, the impact for either islamic or conventional banks are the same and the presence of PSIAs in islamic banks is not something so relevant which can increase much the competitivity of islamic banks with regard to the conventional ones. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks Impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 5 – impact of the leverage ratio on the islamic banks Basel III agreement formalized a simple, transparent, non-risk based leverage ratio. The leverage ratio is intended to constrain the build-up of leverage in the banking sector The leverage ratio requires a definition of capital (the capital measure) and a definition of total exposure (the total exposure or assets measure) Physical or financial collateral, guarantees or credit risk mitigation purchased is not allowed to reduce on balance-sheet exposures High quality liquid assets are included in total exposure measure. Another important point is that Basel II regulatory netting for on balance sheet derivatives and repo style transactions is allowed, which is clearly a positive point for Conventional banks comparatively to Islamic banks which are not allowed to take that kind of short positions. Two column bullet-pointed slide.

Chapter 5 – impact of the leverage ratio on the islamic banks Comparison of the leverage impact: islamic vs conventional banks Conventional banks Today, the leverage ratio is a very hard requirement for investment banks. French banks have not this problem because they all adhere to the universal banking model (retail + investment banking). Investment Bank model will be more impacted by Basel III than wholesale or universal banks. Islamic banks Islamic banks should not experience more constraints under the leverage ratio because there are generally limited before by the risk management of their liquidity (Islamic assets and products are generally less liquid than conventional products). As the business model developed by Islamic banks is more a universal banking model, and as deposits/loans ratios are higher than in conventional (Morgan Stanley research paper on Qatari banks – 11/2011), leverage ratio will not be a real constraint for islamic banks. For example, leverage ratio for Qatari Banks and Emerging banks is generally between 5 and 10% of the own funds when conventional banks are generally between 2 and 4%. Clearly, the leverage ratio is a measure that will increase the competitivity of the islamic banks as regard to the conventional banks. For example, it was not anormal in the past to see some banks with a leverage ratio of 1.5 or 2%. With a limit of 3%, these banks should not have a total exposure above 33 times their capital. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks Impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Chapter 6 – impact of the leverage ratio on the islamic banks The Basel committee has decided to setup minimal Regulatory standards for liquidity risk and now asks the bank to create new monitoring tools to be used by supervisors to control liquidity risks. Liquidity risk is the risk that the Bank will be unable to meet its payment obligations associated with its financial liabilities when they fall due and to replace funds when they are withdrawn. The consequence may be the failure to meet obligations to repay depositors and financing parties and fulfill financing commitments. The core of the framework consists of two ratios, the Liquidity coverage Ratio (LCR) and the Net Stable funding ratio (NSFR). These two ratios have been developed to achieve these objectives. The LCR and NSFR are not definitely defined and the Basel Committee pursues its calibration in order to be “absorbable” by the banks and not too much penalizing for the economies financing. The LCR will become binding on January 1st, 2015 The NSFR will become binding on January 1st, 2018 During the observation period (from 1/1/2013), some substantial modifications can be decided by the Basel Committee. Two column bullet-pointed slide.

Chapter 6 – impact of the leverage ratio on the islamic banks The liquidity coverage ratio (LCR) aims at strengthening banks’ short-term liquidity profile. It defines the level of Liquidity buffer to be held to cover short-term funding gaps under severe Liquidity stress, under a time horizon of 30 days. The liquidity coverage ratio (LCR) aims at strengthening banks’ short-term liquidity profile. It defines the level of Liquidity buffer to be held to cover short-term funding gaps under severe Liquidity stress, under a time horizon of 30 days. The Net Stable Funding Ratio (NSFR) is more a long term liquidity constraint. Its objective is to strengthen banks’ medium- to long-term liquidity profile. It defines the minimum acceptable amount of stable funding in a stress scenario with an horizon of one year. The NSFR is problematic because it is not in accordance with the primary activity of banks, which the transformation of the liquidity collected… Two column bullet-pointed slide.

Chapter 6 – impact of the leverage ratio on the islamic banks Two column bullet-pointed slide.

Chapter 6 – impact of the leverage ratio on the islamic banks Comparison of the liquidity impact: islamic vs conventional banks (1/2) Clearly, LCR and NSFR are not calibrated for Islamic banks and do not take into account the specificity of this industry. For the LCR, it misses to Islamic banks the abundance of Shariah Compliant short term instruments For the NSFR, there is no profusion of longer term liabilities that can be withdrawn at short term… Despite this, Basel III, finally, will not penalize more than today Islamic banks for the following reasons: Today, major competitive distortion due to the lack of short term liquidity instruments in Islamic Finance, but also because conventional banks did not have liquidity constraints and that this new framework will be very penalized for them (46% does not respect the LCR and 43% the NSFR) Islamic Banks are limited, since their origin, in terms of liquidity so, Basel III impact will be much less important than for conventional banks In general, Islamic banks are largely deposit funded (over 50% in general) with mainly maturities less than one year. As Basel III allows banks to include the portion of the Short term deposits with a 10% haircut, we can expect the NSFR will not be so constraining for Islamic Institutions. Establishment of the IILM, to create and issue short-term Shari’ahcompliant financial instruments to facilitate effective cross-border Islamic liquidity management. Two column bullet-pointed slide.

Overview of Basel III framework Impact of the new capital requirements and ratios on Islamic banks Basel III impact on the risk computation of islamic banks Capital conservation buffer and countercyclical buffer in islamic banks Impact of the leverage ratio on the islamic banks Basel III new liquidity ratios on the islamic banks Conclusion Two column bullet-pointed slide. Source: Text

Conclusion (1/2) Despite the fact that Islamic finance holds global appeal in its provision of Shariah-compliant financial services for both Muslims and non-Muslims, the Basel III has so far often failed to make a distinction between conventional and Islamic finance. Based on this theorical analysis, we can say that Basel III will have a limited impact on the risk, own funds and regulatory ratios compared to conventional banks In effect, these banks have taken higher risks regarding their own funds and in a spirit of maximization their return on equity, have a regulatory ratio, in general, a little bit above the limit (between 8 and 12%). When at the same time, Islamic banks already maintain capital levels well above the current regulatory minimum. (> 12% in general). And with the recent crisis, major parts of these banks have initiated a rethink of their business model in order to limit Basel III impact with, sometimes, big consequences: in France, local authorities lending market was deserted by the historical commercial banks as the maturities are too high… Concerning the liquidity, the new ratios, LCR and NSFR, will require Islamic banks to hold more liquid assets for wholesale funding than they are required to under the existing liquidity framework but as for the own funds, we can anticipate that the impact will be inferior than in the conventional system as the islamic banks are historically constrained in terms of liquidity and as there are historically well capitalized as regard to their exposures. Two column bullet-pointed slide.

Conclusion (2/2) Comparatively with conventional banks, Islamic banking industry seems to be less impacted by Basel III as the business model is more conservative and derivatives and short selling is forbidden. It is a possibility for them to increase their international competitively as regard as the big impact that Basel III has in the business model of conventional banks As Islamic banks cannot adopt Basel III without modification according to their specificities, IFSB should adapt theses new regulations in order to permit to Islamic banks to adopt the new international standards. The next step of this research is to stand the definitive vote of the European transposition of Basel III and réalize a comparative and rigorous analysis in order to see Basel III impacts in islamic and conventional banks by using a representative panel of conventional (investment and wholesale) and islamic banks. It will be the topic of the next research paper incha Allah. Two column bullet-pointed slide.

Chapter 6 – impact of the leverage ratio on the islamic banks Thank you for your attention Adel.harzi@dexia.com Two column bullet-pointed slide.